Long Run Costs - Economies and Diseconomies of Scale
Economies of Scale
Economies of scale are the cost advantages from expanding the scale of production
in the long run. The effect is to reduce average costs over a range of output.
These lower costs represent an improvement in productive efficiency and can also
give a business a competitive advantage in the market-place. They lead to lower
prices and higher profits – a positive sum game for producers and consumers.
We make no distinction between fixed and variable costs in the long run because all
factors of production can be varied. As long as the long run average total cost
(LRAC) is declining, economies of scale are being exploited.
Long Run Output (Units)
Total Costs (£s)
Long Run Average Cost (£ per unit)
1000
12000
12
2000
20000
10
5000
45000
9
10000
80000
8
20000
144000
7.2
50000
330000
6.6
100000
640000
6.4
500000
3000000
6
Returns to scale and costs in the long run
The table below shows how changes in the scale of production can, if increasing returns to
scale are exploited, lead to lower long run average costs.
Factor Inputs
Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total Cost
Average
Cost
Scale A
5
3
4
100
3256
32.6
Scale B
10
6
8
300
6512
21.7
Scale C
15
9
12
500
9768
19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Because the % change in output exceeds the % change in factor inputs used, then, although
total costs rise, the average cost per unit falls as the business expands from scale A to B to C.
Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns available to a
company growing in size in the long run.
An example of this is the computer software business. The overhead costs of developing new
software programs such as Microsoft Vista or computer games such as Halo 3 are huge - often
running into hundreds of millions of dollars - but the marginal cost of producing one extra copy
for sale is close to zero, perhaps just a few cents or pennies. If a company can establish itself in
the market in providing a piece of software, positive feedback from consumers will expand the
installed customer base, raise demand and encourage the firm to increase production.
Because the marginal cost is so low, the extra output reduces average costs creating
economies of size.
Lower costs normally mean higher profits and increasing financial returns for the shareholders.
What is true for software developers is also important for telecoms companies, transport
operators and music distributors. We find across so many different markets that a high
percentage of costs are fixed the higher is demand and output, the lower will be the average
cost of production.
Long Run Average Cost Curve
The LRAC curve (also known as the „envelope curve‟) is usually drawn on the assumption of
their being an infinite number of plant sizes – hence its smooth appearance in the next diagram
below. The points of tangency between LRAC and SRAC curves do not occur at the minimum
points of the SRAC curves except at the point where the minimum efficient scale (MES) is
achieved.
If LRAC is falling when output is increasing then the firm is experiencing economies of scale.
For example a doubling of factor inputs might lead to a more than doubling of output.
Conversely, When LRAC eventually starts to rise, the firm experiences diseconomies of scale,
and, If LRAC is constant, then the firm is experiencing constant returns to scale
Costs
SRAC1
SRAC3
SRAC2
LRAC
AC1
AC2
AC3
Q1
Q2
Q3
Output (Q)
There are many different types of economy of scale. Depending on the characteristics of an
industry or market, some are more important than others.
Internal economies of scale (IEoS)
Internal economies of scale come from the long term growth of the firm itself. Examples
include:
1. Technical economies of scale: (these relate to aspects of the production process
itself):
a. Expensive capital inputs: Large-scale businesses can afford to invest in
specialist capital machinery. For example, a supermarket might invest in
database technology that improves stock control and reduces transportation and
distribution costs. Highly expensive fixed units of capital are common in nearly
every mass manufacturing production process.
b. Specialization of the workforce: Larger firms can split the production
processes into separate tasks to boost productivity. Examples include the use
of division of labour in the mass production of motor vehicles and in
manufacturing electronic products.
c. The law of increased dimensions (or the “container principle”) This is linked
to the cubic law where doubling the height and width of a tanker or building
leads to a more than proportionate increase in the cubic capacity – the
application of this law opens up the possibility of scale economies in distribution
and freight industries and also in travel and leisure sectors with the emergence
of super-cruisers such as P&O’s Ventura. Consider the new generation of supertankers and the development of enormous passenger aircraft such as the Airbus
280 which is capable of carrying well over 500 passengers on long haul flights.
The law of increased dimensions is also important in the energy sectors and in
industries such as office rental and warehousing. Amazon UK for example has
invested in several huge warehouses at its central distribution points – capable
of storing hundreds of thousands of items.
d. Learning by doing: There is growing evidence that industries learn-by-doing!
The average costs of production decline in real terms as a result of production
experience as businesses cut waste and find the most productive means of
producing output on a bigger scale. Evidence across a wide range of industries
into so-called “progress ratios”, or “experience curves” or “learning curve
effects”, indicate that unit manufacturing costs typically fall by between 70% and
90% with each doubling of cumulative output. Businesses that expand their scale
can achieve significant learning economies of scale.
Cost
(Per unit of output)
Economies of Scale
A
B
LRAC1
Learning
economies
C
LRAC2
Output
2. Monopsony power: A large firm can purchase its factor inputs in bulk at discounted
prices if it has monopsony (buying) power. A good example would be the ability of the
electricity generators to negotiate lower prices when finalizing coal and gas supply
contracts. The national food retailers have monopsony power when purchasing their
supplies from farmers and wine growers and in completing supply contracts from food
processing businesses. Other controversial examples of the use of monopsony power
include the prices paid by coffee roasters and other middle men to coffee producers in
some of the poorest parts of the world.
3. Managerial economies of scale: This is a form of division of labour where firms can
employ specialists to supervise production systems. Better management; increased
investment in human resources and the use of specialist equipment, such as networked
computers can improve communication, raise productivity and thereby reduce unit costs.
4. Financial economies of scale: Larger firms are usually rated by the financial markets
to be more „credit worthy‟ and have access to credit with favourable rates of borrowing.
In contrast, smaller firms often pay higher rates of interest on overdrafts and loans.
Businesses quoted on the stock market can normally raise new financial capital more
cheaply through the sale of equities to the capital market.
5. Network economies of scale: (Please note: This type of economy of scale is linked
more to the growth of demand for a product – but it is still worth understanding and
applying.) There is growing interest in the concept of a network economy. Some
networks and services have huge potential for economies of scale. That is, as they are
more widely used (or adopted), they become more valuable to the business that
provides them. We can identify networks economies in areas such as online auctions
and air transport networks. The marginal cost of adding one more user to the
network is close to zero, but the resulting financial benefits may be huge because each
new user to the network can then interact, trade with all of the existing members or
parts of the network. The rapid expansion of e-commerce is a great example of the
exploitation of network economies of scale. EBay is a classic example of exploiting
network economies of scale as part of its operations.
The container principle at work!
Economies of scale – the effects on price, output and profits for a profit maximizing firm
Scale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising
producer will produce at a higher output (Q2) and charge a lower price (P2) as a result – but the
total abnormal profit is also much higher (compare the two shaded regions).
Both consumer and producer surplus (welfare) has increased – there has been an improvement
in economic welfare and economic efficiency – the key is whether cost savings are passed onto
consumers!
MC1
Costs
Profit at Price P1
Profit at Price P2
SRAC1
P1
SRAC2
P2
MC2
AR
(Demand)
MR
Q1
Q2
Output (Q)
External economies of scale (EEoS)
External economies of scale occur outside of a firm but within an industry. For example
investment in a better transportation network servicing an industry will resulting in a decrease
in costs for a company working within that industry, thus external economies of scale have been
achieved. Another example is the development of research and development facilities in
local universities that several businesses in an area can benefit from. Likewise, the relocation
of component suppliers and other support businesses close to the centre of manufacturing
are also an external cost saving.
Agglomeration economies may also result resulting from the clustering of similar businesses
in a distinct geographical location be it software businesses in Silicon Valley or investment
banks in the City of London.
Economies of Scale – The Importance of Market Demand
The market structure of an industry is affected by the extent of economies of scale available
to individual suppliers and by the total size of market demand. In many industries, it is possible
for smaller firms to make a profit because the cost disadvantages they face are relatively small.
Or because product differentiation allows a business to charge a price premium to
consumers which more than covers their higher costs.
A good example is the retail market for furniture. The industry has some major players in each
of its different segments (e.g. flat-pack and designer furniture) including the Swedish giant
IKEA. However, much of the market is taken by smaller-scale suppliers with consumers willing
to pay higher prices for bespoke furniture owing to the low price elasticity of demand for highquality, hand crafted furniture products. Small-scale manufacturers can therefore extract the
consumer surplus that is present when demand is estimated to have a low elasticity of
demand.
Economies of Scope
These are different from economies of scale! Economies of scope occur where it is cheaper to
produce a range of products rather than specialize in just a handful of products. And they can
be exploited when a business owns a resource that can be used more than once in different
ways!
For example, in the increasingly competitive world of postal services and business logistics, the
main service providers such as Royal Mail, UK Mail, Deutsche Post and the international
parcel carriers including TNT, UPS, and FedEx are broadening the range of their services and
making more better use of their existing collection, sorting and distribution networks to reduce
costs and earn higher profits from higher-profit-margin and fast growing markets.
A company’s management structure, administration systems and marketing departments
are capable of carrying out these functions for more than one product.
Expanding the product range to exploit the value of existing brands is a good way of
exploiting economies of scope. Perhaps a good example of “brand extension” is the Easy
Group under the control of Stelios where the distinctive Easy Group business model has been
applied (with varying degrees of success) to a wide range of markets – easy Pizza, easy
Cinema, easy Car rental, easy Bus and easy Hotel to name just a handful! Procter and Gamble
is the largest consumer household products maker in the world. Its brands include Crest,
Duracell, Gillette, Pantene, and Tide, to name just a few. Twenty four of its brands make over
$1 billion in sales annually.
Another example of an economy of scope might be a restaurant that has catering facilities and
uses it for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz
room in the evenings. Or a computing business can use its network and databases for many
different uses.
Case Study: Investment in Sports Grounds
Hotels are a hot topic at sports venues. The owners of these venues are looking for ways to
make better return on their assets. The solution is to explore new business opportunities, invest
in extensive modernisation and spend cash on large-scale redevelopment schemes.
Capacity utilisation is an important challenge facing a sporting venue. There are only so many
cricket matches, grand prix races or rugby games that draw spectators.
By adding purpose-built conference, banqueting and leisure facilities, sports venues can tap
into a different customer base. A hotel facility can attract demand from businesses looking for
corporate hospitality and conferences. Having a hotel also allows a venue to access consumer
spending on short breaks – one of the fastest growing segments of the leisure industry. Most of
the planned hotels will be branded (e.g. Holiday Inn, Marriott) which allows the venue to benefit
from a trusted hotel name and gets access to established distribution channels.
Source: Business Cafe
Minimum Efficient Scale (MES)
The minimum efficient scale (MES) is the scale of production where the internal economies of
scale have been fully exploited. The MES corresponds to the lowest point on the long run
average cost curve and is also known as an output range over which a business achieves
productive efficiency.
The MES is not a single output level – more likely we describe the minimum efficient scale as
comprising a range of outputs where the firm achieves constant returns to scale and has
reached the lowest feasible cost per unit.
Costs
Revenues
LRAC
Decreasing returns –
diseconomies of scale
Increasing return to scale – economies of
scale - falling LRAC
MES
Q2
Output (Q)
The MES depends on the nature of costs of production in a specific sector or industry.
1. In industries where the ratio of fixed to variable costs is high, there is plenty of scope
for reducing unit cost by increasing the scale of output. This is likely to result in a
concentrated market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed
economies of scale may act as a barrier to entry because existing firms have achieved
cost advantages and they then can force prices down in the event of new businesses
coming in!
2. In contrast, there might be only limited opportunities for scale economies such that the
MES turns out to be a small % of market demand. It is likely that the market will be
competitive with many suppliers able to achieve the MES. An example might be a large
number of hotels in a city centre or a cluster of restaurants in a town. Much depends on
how we define the market!
3. With a natural monopoly, the long run average cost curve continues to fall over a huge
range of output, suggesting that there may be room for perhaps one or two suppliers to
fully exploit all of the available economies of scale when meeting market demand.
Diseconomies of scale
Diseconomies are the result of decreasing returns to scale.
The potential diseconomies of scale a firm may experience relate to:
1. Control – monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly – this links to the concept of the
principal-agent problem – how best can managers assess the performance of their
workforce when each of the stakeholders may have a different objective or motivation
which can lead to stakeholder conflict?
2. Co-ordination - it can be difficult to co-ordinate complicated production processes
across several plants in different locations and countries. Achieving efficient flows of
information in large businesses is expensive as is the cost of managing supply
contracts with hundreds of suppliers at different points of an industry’s supply chain.
3. Co-operation - workers in large firms may develop a sense of alienation and loss of
morale. If they do not consider themselves to be an integral part of the business, their
productivity may fall leading to wastage of factor inputs and higher costs. Traditionally
this has been seen as a problem experienced by the larger state sector businesses,
examples being the Royal Mail and the Firefighters, the result being a poor and costly
industrial relations performance. However, the problem is not concentrated solely in
such industries. A good recent example of a bitter industrial relations dispute was
between Gate Gourmet and its workers.
Avoiding diseconomies of scale
A number of economists are skeptical about diseconomies of scale. They believe that proper
management techniques and appropriate incentives can do much to reduce the risk of industrial
strife. Here are three of the reasons to doubt the persistence of diseconomies of scale:
1. Developments in human resource management (HRM). HRM is a horrible phrase to
describe improvements that a business might make to procedures involving worker
recruitment, training, promotion, retention and support of faculty and staff. This becomes
critical to a business when the skilled workers it needs are in short supply. Recruitment
and retention of the most productive and effective employees makes a sizeable
difference to corporate performance in the long run.
2. Performance related pay schemes (PRP) can provide financial incentives for the
workforce leading to an improvement in industrial relations and higher productivity.
Another aim of PRP is for businesses to reward and hang onto their most efficient
workers. The John Lewis Partnership is often cited as an example of how a business
can empower its employees by giving them a stake in the financial success of the
organization.
3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution
as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of
reducing costs whilst retaining control over production although there may be a price to
pay in terms of the impact on the job security of workers whose functions might be
outsourced overseas.
Case Study: Amazon – Economies of Scale and Scope
Increased dimensions: Firstly, the company invested in enormous warehouses to stock its
inventory of books, DVDs, computer peripherals. This allows it to benefit from the law of
increased dimension.
Buying power: Amazon has significant monopsony power when it purchases books directly
from publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit
margin.
Learning by doing and first-mover advantage: Amazon is benefiting from learning by doing
having been one of the first major players in the online retail sector. The unit costs of production
tend to decline in real terms as a result of production experience as businesses cut waste and
find the most productive means of producing output on a bigger scale
Pre-Orders - Amazon use a pre-order system for customers which allows it to capture early
demand and improve stock (or inventory) forecasting.
Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one
advantage is that it has lower invested capital in the business and it frees up resources for
customer fulfillment and investment in new technology – Amazon distributes to over 200
countries.
Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number
of weeks an item remains in stock. For Amazon this is half that of a physical store – and the
benefit is a reduction in obsolescence loss (the value of unsold stock is estimated to decline by
30% per year)
Economies of scale help to give Amazon a significant cost advantage. The business is also
looking to create economies of scope from marketing and broadening the range of products
available through the Amazon brand. Among the innovative business ideas under development
we can identify:
Merchants@/Marketplace which gives independent (third party) sellers the opportunity
to sell their products through the Amazon platform
Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a
range of partners such as Marks and Spencer, Lacoste, Mothercare and Timex
CreateSpace – a new self-publishing platform for books, music and video
Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines
and newspapers to a high-resolution electronic paper display that looks and reads like
real paper,
Amazon now sells nearly one fifth of the books bought in the UK each year.
Suggestions for further reading on economies of scale and scope
Consoles look to hit their stride (BBC news, July 2008)
Cost headache for games developers (BBC news, December 2007)
Economies of scale in printing (Tutor2u economics blog, March 2008)
GM installs world's biggest rooftop solar panels (Guardian, July 2008)
How world's biggest ship is delivering our Christmas - all the way from China (Guardian)
Mobile web reaches critical mass (BBC news, July 2008)
Salad production on a massive scale (BBC news, June 2008)